Focus on Economic Data: The Federal Reserve and Monetary Policy, May 1, 2013

INTRODUCTION

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets approximately every six weeks to determine the nation's monetary policy goals and, specifically, to set the target for the federal funds rate (fed funds rate). The fed funds rate is the interest rate at which banks lend their balances at the Federal Reserve to other banks, usually overnight.

The FOMC has maintained the target federal funds rate at a range of 0 to 1/4 percent since its December 16, 2008 meeting. The fed funds rate has been kept at this historically low level due to over a year of low and often negative real GDP growth, significant numbers of non-farm employment losses and very high unemployment.

This lesson focuses on the April 25, 2012, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

TASK

Explain the meaning of the May 1, 2013, Federal Open Market Committee decision concerning the target for the federal funds rate.

Identify the current monetary policy goals of the Federal Reserve and the factors that have recently influenced monetary policy goals.

Identify the current actions taken by the Federal Reserve to achieve its monetary policy goals.

Explain the intended effects of open market operations.

PROCESS

First, a Quick Review of Recent Monetary Policy History

On December 1, 2008, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) declared that the U.S. economy reached a peak in the business cycle in December, 2007, and a recession had begun.

At its December 8, 2008, meeting, the Federal Open Market Committee established the target for the federal funds rate at a range of 0 to 1/4 percent. This historically low fed funds rate target was aimed directly stimulating the economy through lower interest rates. The Fed has maintained at this low level for the federal funds rate to this time.

On September 20, 2010, the Business Cycle Dating Committee of the National Bureau of Economic Research determined that a trough in business activity occurred in the U.S. economy in June, 2009, and that the 2008-2009 recession had ended.

After the "official" end of the recession, the FOMC's target for the federal funds rate has not changed. Other strategies to improve banking system liquidity and stimulate economic growth and employment have been added to the Fed's tool box.

Students: Do you feel like the U.S. is still in a recession? What evidence do you have?

What did the FOMC have to say, more than three years after pushing its primary tool down to a record low in order to reduce interest rates and stimulate credit markets?

Remember, the primary monetary policy goals of the Federal Reserve, as established by the Employment Act of 1946, are to "promote maximum employment, production, and purchasing power." In other words, policies should create jobs, increase output, and keep the price level stable.

[Teacher Note: For information about the Employment Act of 1946, see the Federal Reserve Bank of St.Louis online article, “The Employment Act of 1946: Some History Notes,” by C. J. Santoni (November, 1986). ' ]

Note: Unless otherwise cited, quoted material in this lesson is from the FOMC's May 1, 2013, monetary policy press release.

The FOMC announced, "Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace."

Students: What does "expanding at a moderate pace" mean? A dictionary defines "moderately" in this context as, "a: tending toward the mean or average amount or dimension; b: having average or less than average quality : mediocre"]

Students: What can happen if the economy grows too slowly and the population continues to grow at a normal pace?

More details from the May 1 FOMC announcement, "Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable."

Inflationary pressures have not been strong enough for the FOMC to choose a higher federal funds rate target. The trade-off between inflation and growth as potential policy targets has continued to lean toward growth.

The FOMC then commented on its progress toward achieving its macroeconomic goals - fostering maximum employment and maintaining price stability.

"Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee continues to see downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective."

The Fed will continue its "Large Scale Asset Purchases" program to use its balance sheet to improve the stability of the banking system and encourage banks to make loans.

"To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."

What about the Future?

"The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives."

Students: Can you explain why the FOMC continues to be concerned about possible price instability? What might the FOMC do if inflation is a stronger possibility?

The Federal Finds Rate Target

Remember, the federal funds rate the interest rate at which depository institutions (member banks) lend balances to each other overnight. The member banks must meet their reserve requirements at the end of each day. The FOMC establishes the target rate for trading in the federal funds market.

"To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent."

Figure 1, below, shows the recent history of the federal funds rate target, prior to and after the recent recession.

[Teacher Note: Is there any potential problem when the FOMC announces a specific time-frame for the current policy or a goal of a specific unemployment rate? Is a less specific statement like "extended period" better? Some argue that planners, investors, employers, etc., may respond more positively if they know more about future policy. The specific date may reduce their uncertainty about the economy. Do you agree or disagree?]

The FOMC vote was not unanimous. There was one dissenter.

"Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations." (Esther L. George is President and Chief Executive Officer of the Federal Reserve Bank of Kansas City.)

Note: The Federal Reserve Board of Governors has produced an online video program explaining the "maturity extension," or "Large Scale Asset Purchases" monetary policy programs.[ www.federalreserve.gov/faqs/money_15070.htm]

What Will the Fed Look For in the Future?

When assessing the health of the economy and the impact of past, current an future monetary policy actions, the FOMC will look closely at GDP growth, employment/unemployment, and other economic data.

Figure 2, below, shows the recent history of growth rates of U.S. real gross domestic product (real GDP). How have the FOMC decisions reflected the real GDP growth pattern?

Students: Is a 2.5 percent real GDP growth rate enough?

Figure 3, below, shows the recent history of monthly U.S. unemployment rates.

Students: If the U.S. unemployment rate remains as high as 7.5 percent, how will this potentially impact consumers and producers?

U.S. output is increasing, although erratic from quarter to quarter. The U.S. unemployment rate continues to remain very high. Look again at Figures 2 and 3. Can you see the time period of the recession, December, 2007 through June, 2009?

The FOMC has kept the federal funds rate target at a very low level of 0 to .25 percent during the recession and to the present time, but the economy continues to recover very slowly. Thus, the Fed continues a low interest rate policy that "accommodates" growth. QE2 (the second round of quantitative easing), purchases of almost $800 billion in securities, intended to provide more market liquidity has officially ended, but continued policies to strengthen the banking system and promote growth continue.

Is there a threat of inflation? Take a look at the recent history of changes in the price level, as measured by the CPI-U, Figure 3, below. The majority of the increases in the price level for the past two months has been energy and food prices.

See Figure 4, below, for the recent history of changes in the U.S. price level.

If you leave out the highly volatile energy (especially gasoline) prices over this time period, there has been very little inflation and occasionally some concern about the prospects for deflation. Recently, many observers have feared a recurrence of inflation, driven by energy prices and continued government budget deficits.

Students: Are you worried about inflation? How have higher gasoline or other prices affected you and your family?

How would each of the above policy tools (actions) impact the economy?

Note: The Federal Reserve Bank of Philadelphia has published an online lesson, "Monetary Policy." Description: "Working in groups, students develop an understanding of monetary policy. Students learn about the indicators the Fed uses to determine what changes, if any, should be made to the course of monetary policy." Link: https://www.philadelphiafed.org/education/money-in-motion/lesson-plans/

CONCLUSION

This FOMC monetary policy announcement began with a quick assessment of current U.S. economic conditions. "Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace."

Previous FOMC statements have also referred to a "moderate pace" of growth, after a period of slow growth. The beginning of the May 1 statement was optimistic, but still cautious. The rate of U.S. real GDP growth has been erratic and the unemployment rate remains at 7.5 percent. Job growth in April, 2013, was much better than the previous month, but a clear pattern of growth has not yet been identified.

The current monetary policy continues to be "accommodative." Low interest rates and other policies to encourage lending and investment are focused directly on the Fed's goals to promote economic growth and full employment.

The FOMC federal funds rate action in May was to keep the target range for the federal funds rate at 0 to 1/4 percent "at least as long as the unemployment rate remains above 6-1/2 percent ." Previous FOMC statements have more clearly described their long-term policy as "at least through late 2014." Many have interpreted this to mean that the FOMC wants to provide some policy stability to the benefit of planners, investors, lenders and borrowers. Stable policies can reduce the risk of decision-making.

Despite what may seem like a more optimistic view, Chairman Ben S. Bernanke and the FOMC recognize the potential threats to the U.S. and global recovery, and reaffirmed that the Fed is ready to act if economic growth slows or if the threat of inflation worsens.

Students: If the Fed has to make a decision about whether to promote economic growth or stop inflation, which should be the priority? Describe the trade-off the Fed will face?

ASSESSMENT ACTIVITY

EXTENSION ACTIVITY

Idea #1. The Federal Reserve Bank of Philadelphia has published an online activity called "The Case of the Gigantic $100,000 Bill." In this lesson, students participate in a demonstration of the money creation process using a large $100,000 bill. Expansions of the money supply caused by successive deposits and loans are traded on the board so that students can observe the process. Students learn to calculate the upper bound of the money creation process using the simple money multiplier.

Idea #2. The Federal Reserve Bank of San Francisco publishes a website called "The Economy: Crisis and Response," with information about the Fed's policies during the recession and banking crisis.

Description: "The financial market turmoil that began in 2007 led to a severe global economic downturn. The causes of the crisis, the effects on global financial markets, and the spillover to the economy are examined here."